Where were the auditors?

– in which Bob Tricker explains why he resigned from the Institute of Chartered Accountants in England and suggests a provocative future for auditors*

In the ongoing crisis facing financial institutions around the world, plenty of questions are being asked: why did the independent directors not act, did they even understand the risks in the business models being pursued; did the regulators fail; were the credit agencies at fault; are the risks of securitisation still properly understood; did short-term performance bonuses encourage greed and excessive risk taking?

But a crucial question remains: where were the auditors? Audit reports reassured readers about these companies’ accounts even though, as we now know, the underlying strategic model was suspect and the businesses exposed to massive risk, even the possibility of trading when insolvent.

In the original 19th century model of the joint-stock company, the state permitted incorporation of limited-liability entities provided certain safeguards were met to protect society. Auditors, appointed from amongst the investors, reported to these shareholder-owners that the directors of their company had faithfully recorded the company’s financial situation.

Then the accounting profession emerged. Small firms at first but, as companies grew in scale and complexity, they grew larger. Mergers enabled them to grow further. By the end of the twentieth century the world’s major listed companies were audited by just five vast, international accounting firms.

However, in essence the auditors’ duty has not changed since the founding years. It is still to report that the information given by the directors to the shareholders reasonably reflects the truth. But the relationship of the auditors to the companies they audit has changed. As scale and complexity increased, the role of the auditors properly became more professional. Inevitably, their relationships with the directors of their client companies grew closer. Although in many jurisdictions the shareholders still voted on a resolution to appoint the auditors, it was the board of directors who really made the decisions. And although nominally the auditors reported to the shareholders of the company, their detailed reports went to the directors.

Inevitably, a close relationship developed between the auditors and the staff of their client, particularly in the finance department. Issues that arose during the audit – questions about asset valuations, capital or revenue decisions, risk assessment or management control, for example – were resolved without the board even being aware of them. So audit committees were introduced, first in the US and then, following the Cadbury Report, in the UK. Sub-committees of the main board, these audit committees relied on independent outside directors to provide a bridge between company and auditor, avoiding too close a relationship between executive directors and audit staff, and ensuring that the directors were fully aware of audit issues.

Following the Enron debacle, the listing rules of most stock exchanges demanded audit committees composed entirely of independent directors, the rotation of audit managing partners, the prohibition of consultancy work for their audit clients, and a cooling-off period before audit staff could join the finance department of a client. The rotation of audit firms, though called for by some, was not demanded.

But I believe the issues go deeper. The real question is whether audit and accountancy is a profession or a business. Do the auditors offer a service to management or are they part of society’s regulatory function?

In the 1950s I was articled to a professional audit practice, which provided service for a fee. The number of partners was small. The phrase corporate governance had yet to be coined. In those days the accounting profession consisted mainly of relatively small firms. Of course, our partners were keen to be successful. In their community they were respected and well to do; but they were not rich. Neither would they compromise their principles. They would not sign an audit report, stating that the client’s account’s showed a true and fair view, unless the partner was personally convinced that they did. Better to lose a client than your integrity. This was a profession, after all. The audit process demanded absolute objectivity of thought and independence from the client.

How different at the beginning of the 21st century. The five major accounting firms had become vast, international and concentrated. They are major businesses, offering products and solutions, with market share and profit performance as watchwords. Partners were judged by fee generation and growth. Then in 2002 one of the five, Arthur Andersen, collapsed, brought down by the Enron catastrophe in the United States. Then there were four.

Partners’ expectations have been influenced by the remuneration levels of their ‘fat cat’ clients. But auditing is not astro-physics. True, the work demands detailed, intense and up-to-date work, but it is not actually difficult. Admittedly, too, these days the risks of litigation and forced resignation are higher. But the real challenge lies in determining standards and living up to them, as it always did.

When I began my accounting career in England, the Institute of Chartered Accountants was at the head of a self-regulating profession. Today, as the Arthur Anderson saga has shown, the market place, not the profession, regulates. Indeed, I believe that auditing has ceased to be a profession: it has become a business. So after nearly fifty years as a Chartered Accountant, including service as a member of its governing Council, I decided that the profession I had joined no longer existed and resigned my Fellowship.

Of course the business world has changed. Nostalgia has no place in strategic thinking. There is no going back to the profession of half a century ago. But I suspect that, unless auditing rediscovers what it means to be a profession and returns to its roots, state regulation of the audit process will have to be imposed to protect creditors, investors and the wider community.

Serious questions have to be asked about the auditors’ position. Who are their real clients: the directors or the shareholders? The de jure response that the client is the company and that somehow this means the body of shareholders will no longer wash. The de facto reality is that the client is the board, backed up by the board’s audit sub-committee. Is this satisfactory under current circumstances? What are the alternatives?

Consider some options:
1. Open the audit market with the second tier firms playing an increasing role in the audit of major listed companies. There has been slight movement in opening the market for audit. But financial markets like the assurance they think they get from an audit opinion signed by one of the big four firms. Predictably, the partners of the firms in this global oligopoly do not favour this solution.

2. Increase regulation introducing further rules to regulate auditors’ activities. This has been the approach adopted in many countries, with the Sarbannes Oxley Act (SOX) in the US, and tighter regulations and stock exchanges’ listing rules elsewhere. But SOX has proved far more demanding, expensive, and bureaucratic than expected; and less effective, as we see from its failure to identify the exposure underlying the financial institutions that have collapsed.

3. Face reality, require auditors to be appointed by and report to the state. It is the state that permits companies to incorporate, and the state that is responsible for protecting the interests of investors, creditors and other stakeholders. That is why we have regulators. A start could be made by introducing this requirement in those companies that have just been massively funded by the state. Surely, the auditors of companies that have been bailed out should not report solely to the directors. He who pays the piper…

The regulatory organisational structures already exist to manage such a relationship. The regulators, working with the shareholders in general meeting, would appoint, re-appoint, or if necessary replace the auditors, agree their fees and receive their reports. The company would, as now, bear the costs.

In this way cosy relationships between directors and auditors would be avoided. If they reported to the regulator rather than the directors, the auditors would have to develop a new mind set. Moreover, shareholders would now have a direct line to their auditors and the board’s audit committee.

Eventually, such an arrangement could be applied to all listed companies. Shareholders would benefit. Investors would know that their auditors worked for them, just as in the 19th century model.

Bob Tricker
* This is a personal view and the ideas are not necessarily shared by my fellow blogger Professor Chris Mallin nor the Oxford University Press.

Banks in crisis: failures of corporate governance?

Corporate governance has been gaining more predominance around the world over the last decade.  However the last year or so which has brought the financial crisis and the ‘credit crunch’ has seen an unprecedented interest in some of the areas that are central to corporate governance: executive remuneration; boards of directors, independent non-executive directors; internal controls and risk management; the role of shareholders.

However the focus on these areas has brought into sharp relief some of the failings of the present system whether these have been brought about by greed, naivity, or a lack of real appreciation of the risk exposures of banks.

Bankers’ bonuses
Whilst many would agree that bankers have received huge payouts, often for a seeming failing company, bonuses appear likely to be cut, possibly by around 40% or more.  Peter Thal Larsen and Adrian Cox (FT, Page 13, 07/08 Feb 09) in their article ‘Barclays bankers braced for bonus cut’ highlight that even much reduced bonuses are likely to be controversial given that feelings are running high amongst the public and politicians alike.

The generous remuneration packages of executive directors of some of the UK’s largest banks have caught the headlines day after day in recent weeks.  In their article ‘Former executives face bonus grilling’ (FT Page 2, 9^th Feb 09), George Parker and Daniel Thomas mention an interesting historical fact ‘in the early 18^th century, after the bursting of the South Sea bubble, a parliamentary resolution proposed that bankers be tied up in sacks filled with snakes and thrown into the River Thames’!  No doubt there are those who wish the same might happen today although a grilling before the Commons Treasury Committee may prove to be almost as unpleasant an experience!

Adrian Cox’s article ‘Barclays executives must wait longer for bonuses’ (FT, page 2, 11^th Feb 09) highlights that Barclays is trying to design a pay structure that retains staff whilst rewarding long-term performance at a time when banks have been urged to show ‘moral responsibility’ in their remuneration structures.  The pay restructuring will affect not just directors but also senior employees, and other banks including UBS, Credit Suisse, RBS and Lloyds are in a similar position.

Risk Management

‘Former HBOS chiefs accused over risk controls as bankers apologise’ was the striking head of the article by Jane Croft, Peter Thal Larsen and George Parker (FT, page 1, 11^th Feb 09).  Under questioning from the Commons Treasury Committee, Lord Stevenson, Andy Hornby, Sir Tom McKillop and Sir Fred Goodwin all apologised for what had happened at RBS.  Part of the questioning brought to light that a former employee had warned the board of potential risks associated with the bank’s rapid expansion.

Risk management is an area that is bound to gain a higher profile given the extent of the impact of the use of toxic assets which many feel were not well understood.

Where were the institutional shareholders?

Lord Myners, the City minister, has urged shareholders to challenge banks ‘Myners calls on shareholders to challenge reward cultures’ by Adrian Cox and Kate Burgess (FT page 3, 10^th Feb 09). Lord Myners, they state, said that’ institutional investors should look at the content of remuneration reports and ask questions if the data are complex or opaque’.

My view is that it is an ongoing debate as to what extent institutional shareholders should intervene in the affairs of the companies in which they invest (investee companies).  It is widely recognised that engagement and dialogue are useful and necessary for an institutional investor to monitor the activities of investee companies.  However there is a line to be drawn between what it is feasible – and desirable – for the institutional shareholders to do, and what might be seen as undesirable and restrictive.

Sophia Grene article  ‘Funds say they did all they could to warn banks’ (FT, page 9, 8^th Feb 09) highlights the view of the UK’s Investment Management Association that ‘fund managers did all they could to prevent banks hurtling to their doom, but under the current system, shareholders cannot shout loud enough to be heard’  The IMA also indicated a possible way forward for the future ‘investors can only do so much…..maybe we need to take a closer look at how investors and non-executive directors interact.  They’re privy to much more information than the investors’.

Walker Review of the Corporate Governance of the Banking Industry

Sir David Walker has been appointed to lead a review of the corporate governance of the banking industry which will look into remuneration and bonuses, risk management and board composition. The terms of reference can be found at:

http://www.hm-treasury.gov.uk/press_10_09.htm

Bankers abroad

In the US, President Obama has brought in reforms to limit the remuneration of executives to $500,000 at banks which have had a bail out.  Shares could also be given under incentive plans but would only vest once government support had been repaid, ‘Obama gets tough on pay for executives’, Alan Beattie and Edward Luce (FT page 1, 5^th Feb 09).
Chris Mallin

Corporate governance at the heart of political, social, and economic debate

An unprecedented economic crisis now dominates the world economy. Comparisons with previous recessions or the great depression of the 1930s miss the point. The world economy has never been in a situation like this before. Global companies are larger, more complex and interdependent than ever before, financial markets are vast and interrelated in a way previously unknown, and questions of corporate governance – the way power is exercised over all types of corporate entity – are being asked as never before. Consider a few: 

• Where were the directors of the failed financial institutions?
• Why did their independent outside directors not provide the check on over-enthusiastic executive directors, that they are supposed to?
• Did the directors really understand the strategic business models and sophisticated securitised instruments involved?
• Did they appreciate the risk inherent in their companies’ strategic profile?

• Where were the auditors?
• In approving the accounts of client financial institutions did they fully appreciate and ensure the reporting of exposures to risk? Expect some major legal actions as client companies fail. Hopefully, we shall not see another Arthur Andersen – there are only four global accounting firms left!

• Did the credit agencies contribute to the problem by awarding high credit ratings to companies exposed to significant risk? Expect some major changes here.

• Government bailouts of failing banks have produced near nationalised conditions in some cases. That turns governments into major institutional investors. (The Chinese government is the world’s largest institutional investor: maybe there are some insight there – see chapter 8)
• Government bailouts also raise the ethical issue of so-called moral hazard; by protecting bankers from their past reckless decisions, would others be encouraged to take excessive risks in the future?

• Will the experts who designed the sophisticated loan securitisation vehicles and other financial engineering systems be held to account? Are their ideas and enthusiasms now under control? This key issue has not yet been addressed.

• Where were the banking regulators? Although the extent of the crisis is unprecedented, the regulators seem to have been beguiled into complacency. There is some evidence that they might have been taken-over by the industry they were there to regulate. New rules are inevitable. But remember, the US Sarbanes and Oxley Act, drafted hurriedly in response to the Enron collapse and the loss of confidence in the market, has proved far more expensive than expected and has not been entirely successful, as we are now seeing.

• Were any of the financial institutions’ activities illegal? Compare the situation with Enron, where some top executives continued to believe that nothing they had done was wrong, even as they approached jail. No doubt there are investigators pursuing this question right now.

• Finally, did excessive bonuses and share options encourage short-term and unrealistic risk-taking with shareholders funds? Predictably, this has been a major focus of the tabloids. In the future, some control is likely on performance related remuneration. The news that some bankers had lost their fortunes as share prices collapsed was cold comfort to mortgagees who lost their homes, shareholders who lost their savings and employees who lost their livelihoods.

It is fascinating to see that the subject of corporate governance, though not always mentioned as such, has become central to political, social and economic thought.

Bob Tricker